Here is a long and nice article on the current macroeconomics issue by Paul Krugman. I must admit that I share the same view for some of his thoughts, particularly with respect to the misuse of economic models to explain the world and the argument that the market is perfectly efficient and can always maintain that condition. For further discussion, you can see my post here on the issues of Capitalism. To cut it short, I never believe that someone can explain how the market works through some sophisticated mathematical equations and models. Of course you need to make some calculation in economics, but don't expect that everything will work perfectly in accordance with the calculation, there are too many factors which are affecting the economics performance. Now, let us move to today's main theme. What exactly is Ketchup Economics? According to Mr. Krugman, this is related to the assets valuation method use by finance economists in determining whether asset prices are reasonable, i.e. they don't ask whether asset prices made sense because of its real-world fundamentals like earnings, but whether asset prices made sense given other asset prices. Using Larry Summers' parable, the simplified version would be as follows: The "ketchup economists" have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup, therefore they conclude from this fact that the ketchup market is perfectly efficient. Got the message? Using the Ketchup Economists logic of thinking, the fact that the prices of certain assets are going considerably up or down in certain periods should not be questioned as long as the prices of other similar assets are going up or down together. Without a doubt, this is dangerous. But how can we blame them for making this kind of assessment? If we take the assumption that the market is truly efficient, it is useless to make a price valuation based on the fundamental aspects of the assets, since it is the market force, the supply and demand mechanism, that will determine the exact value of those assets. Let me clarify first, while I do believe the concept of Invisible Hand, i.e. the best way to let the economy moves is by letting the force of supply and demand works automatically, I also believe that the market is not always efficient, there would always be a case where the amount of the supply or demand is too high or too low. There are many factors that can affect such amount of supply and demand, and I can assure you that not all of those reasons were made on a reasonable basis. Sometimes people are being in a state of high optimism and are willing to take more risks and then the economy moves forward, in other times people are being too pessimistic and then we're going through a recession. Then, what could be done? To be honest, I don't know yet. Many professional economists have tried to solve the problem, but no one has ever succeeded, so I don't think that I can provide the perfect solution. However, since most victims of the current crisis are major financial institutions, I would suggest that a better supervision mechanism should be implemented by the Government in the near future. We would also need certain regulations that will encourage financial institutions to have a better assessment on their business and investment risks and to ensure that they can always maintain a prudent approach with their risk management. I was quite surprised with the collapse of some major financial institutions back in 2008, it is just ridiculous that from all the possible companies to collapse, those who should actually be the most prudent companies are the ones who were proven not prudent and therefore collapsed firstly. In addition, since most of the major financial institutions are relying on rating companies in determining their risk of investment, it would also be helpful if the Government can start to have a meaningful discussion with major rating companies concerning their rating standards in order to create a better and more prudent rating mechanism. Further elaboration on this idea will surely be needed in the future.

I'm quite shocked with this piece of letter, especially because it was published in the New York Times. What's wrong with being a highly paid lawyer? Is it that bad to work as a lawyer in the United States? How come the shortage of job with high salaries is good for the development of law graduates? And, the most important question is, how on earth can someone made a claim like this: "as the jobs with large salaries disappear, law students will draw on the thoughtfulness, intelligence and perseverance that got them into law school in the first place in order to find employment that they actually find rewarding."

Is he trying to say that having a career as a lawyer would cause law graduates to lose their thoughtfulness, intelligence and perseverance??? Pardon me sir, but among many types of career that can be pursued by a law graduate, I find that being a lawyer provides the biggest opportunity for a law graduate to maintain and increase their thoughtfulness, intelligence and perseverance. It goes without saying that a good lawyer must combine all of those three qualities in order to survive in their job.

Any law firm who truly cares about the quality of their work and talents would be most probably establish a system which will ensure that all of their lawyers are able to maintain those three qualities. These include proper distribution of work, work review mechanism, and systematic training program. Why I believe that those three qualities will be maintained and increased by becoming a lawyer? See some examples below:

• If you want to train a lawyer's perseverance, throw him into a very boring due diligence exercise. It's very important, but everyone knows that it's an administrative paper work. Those who can survive the hellish due diligence exercise will not doubt have a perseverance of a true knight.
  
  
• If you want to train a lawyer's thoughtfulness, throw him into various negotiation meetings with clients and their counter parts. The first experience will always be scary, but it will definitely train his ability to think and act carefully, as he will have to respond to on-the-spot questions and he will need to understand his clients needs and translate those needs into commercially acceptable legal terms. He will also learn to act in a professional manner all the time to ensure that he can gain trust from both sides.
  
  
• If you want to train a lawyer's intelligence, throw him into structuring a complex transaction or make him do some advisory works. That would done the job easily.

And come on, how can someone says that having a job with less salary is good? No sir, that's not good at all. You ask people to be happy with less salary? You're saying that dreaming a career in a big paid law firm is not worthy to be pursued? My suggestion, if you want to cheer up these poor law graduates about their prospective careers, find a better reason next time.

In my post dated 26 August 2009, we have discussed the basic concepts of Libertarian Paternalism, introduction to better policy making, and examples of human errors with respect to daily economic activities. Today, we will discuss some useful guidelines in making better policies and how to implement such guidelines in actual life.

The Six Guidelines of Better Policy Making

According to Thaler and Sunstein, there are 6 basic guidelines for better policy making:

Each will be further discussed below:


1. Expect Error

I guess this is the first guideline to be considered by policy makers. Since most men make mistakes, a good policy will consider such fact and will ensure that the mistakes can be fixed in the easiest way.

What is the actual implication of this guideline? While governments or private institutions can try their best to design a good policy, they must be aware on the possible failures due to human errors and must ensure that the system will be able to sustain and fix such problem. There are many examples for this problem, but let me show a very interesting case as provided by Thaler and Sunstein, that is the case of birth control pills. Some of you might be aware that in one month, most women will take birth control pills for about three consecutive weeks and then stop for one week (due to the menstruation period). Many women have difficulties to adopt to this system and some of them may forget to take their pills in accordance with the required schedule. So what the companies do with this condition? They provide 28 pills in 28 containers, each having a specific number from 1 to 28. However, pills in containers no. 22 till 28 are only placebos made for the sake of compliance by human users, and thus they don't have any effect whatsoever. Interesting isn't it?

2. Default
The "Default" guideline is made due to the fact that most people will take the options which require the least effort, or in other word, people would instinctively take the easiest route in doing something (seems familiar?). In our daily life, the "Default" option represents an option that, if the chooser does not do anything, will cause most people to end with such option, whether the option itself is good or bad. The case will be stronger if there is any suggestion (explicit or implicit) on such "Default" option, i.e. people will most likely take such option without much hesitation.

In reality, we can't avoid this "Default" problem. Governments and private options in many cases need to provide "Default" option, such as the default choice of menu in a fine-dining restaurant or the default choice for investment policies in your pension funds. Now, since the "Default" option is very powerful, it would be best to ensure that any "Default" option is made for the benefit of the people. How can we do this?

There are two possible ways. First, we can design that each "Default" option requires an active approval from the relevant user. This means that a "Default" option will only be applied once it has been approved by the user. However, in several cases, some people ended up with having no benefit simply because they are too lazy to activate their own "Default" option.

The other way is to design the best possible policy that can be made by the government or private institutions and then such policy will be made as the default option, whereas any people who don't agree with such option will always be free to opt out. Take as an example your computer's download system. All major software company requires the user to actively choose whether they want to download a file or not for each downloading session as a default option, instead of the automatic downloading system. Why? Simply because downloading a file automatically might be dangerous (e.g. causing computer virus attack) and you'll need to properly asses such risk whenever you are trying to download a file. Simple, but important. And in each case, you can always change the setting (of course, if your administrator permits you to do that).

3. Understand Mapping
The third guideline deals with the fact that most people will have some difficulties when they are facing complex choices. A good policy will provide some mapping mechanism to its users, enable them to review the possible options in an easier manner and will allow them to choose the best option for them. In other words, we're talking about better disclosure to the public.

Now, let me ask you some simple questions, do you really understand the actual costs for using your credit card ? Or how to calculate your telephone bills? I bet that most of us wouldn't even know.

That's why we need a regulation which would require companies to have better disclosure system. The implementation of the "Understand Mapping" guideline should be cheap and will maintain the basic freedom of choice for consumers. It would also be good for the business because it can increase fair competition without having to use excessive litigation method (such as the use of Anti Monopoly and Unfair Competition Commission) or forced price control.

As an example, let us see the telecommunication industry. Imagine that the Government now requires each telecommunication provider to provide all relevant information related to the costs of their services and to provide a simple costs comparison with other providers. The information should also be easy to be obtained by all consumer. With this kind of policy, we would have a better understanding on the actual costs for using telecommunication services and can easily spot the best provider which would satisfy our needs. Each telecommunication company will also have better incentives to increase their business efficiency and to optimize their services due to this information disclosure system. Wouldn't that be nice?

4. Give Feedback
It goes without saying that a good policy will be able to provide a feedback to the user, whether they have done well, or were actually making mistakes. A nice example provided by Thaler and Sunstein is our internal computer system that warns us before our computer battery completely runs out.

Based on this guideline, I also have an idea where there is an integrated system to supervise the use of credit cards by each person. We know that each credit card has its own limit. However, in many cases, rather than acting as a limiter for people in using credit cards, such limit encourages people to spend their credit cards up to its maximum limit, and in some other cases, people tend to obtain many credit cards to increase their total credit cards limit. All of these are totally wrong.

Now, by using this integrated system, the banks would know how many credit cards are owned by a person, including each of their limits. Whenever certain amount of the combination of the limits have been reached (which should be in accordance with the credit worthiness of the user), all of the credit cards wouldn't be available for use. We have this supervision system for banking loan and credits application, why not for credit cards? We can help many people by using this kind of system. Remember, having many credit cards doesn't mean that you're becoming richer.

5. Structure Complex Choices
Actually, this guideline is deeply related to Guideline no. 3. When people are facing complex choices, they tend to simplify the choice. That's why a good policy maker will structure its policies to be easily understood and choosed by the user. One of the most useful methods that is being widely used is the "Collaborative Filtering."

Don't be afraid with the name, since it's basically a public review system and the internet really helps the development of this method. As an example, when you want to buy a law textbook and you have many choices but don't have enough time to read all of the available books, what would you do? You'll ask other people's opinion right? In the world wide web, you can simply search the title using Goggle or Yahoo and then you can see whether any people have made a review on such book. It is easy, cheap, and in most cases would be helpful for us in making an efficient decision.

6. Incentives
This is my favorite guideline and has been discussed various times in my other posts. It's very simple, people respond to incentives, they actually calculate the costs and benefits of everything, though maybe not as complex as a professional would be. Therefore, a good policy should always calculate the best incentive to be used in order to make such policy can be effectively applied.

Some legal scholars claim that currently most regulations are no longer effective to bind the people and therefore they are questioning the efficacy of the law itself. If only these people understand the basic nature of men, they would not say such a thing. You can't expect people to follow the law if you don't provide a suitable incentives for them. If you think that people will act according to a law only because of morality or religious reasons, I suggest that you need to reevaluate again your idea, or I'm afraid you will be frustrated.

I wouldn't provide any examples for this guideline as I believe you have seen many in my previous posts and I assure you that you will see more in my future posts.
Concluding Remarks

I hope this article can enlighten you on how the government and private institutions should design a policy which would maximize the benefit for the people without minimum cost to the people's freedom of choice. I personally agree with most of this Libertarian Paternalism movement, but I need to put some qualification here. What matter most to me is finding the most effective policy in improving people's live, so when the circumstances show that preserving free choice would not be efficient, some other methods would be needed. This is especially relevant when we're dealing with major criminal acts, such as terrorism, money laundering, and corruption. Of course it would be really nice to reduce these criminal acts by using positive incentives, but don't put too much faith on that.

All right, this is indeed a hilarious post from Greg Mankiw. The statistics show that children from higher income families are getting higher average SAT scores, and some people claim that there is a correlation between income and better result of tests. However, Mr. Mankiw theorizes that the correlation is not on the income rate, but on the fact that smart people are making more money and these people pass their genes to their children, thus smart children comes from smart parents not from rich parents. Okay, I'm not a professional statistician, but when dealing with statistics, I always remember what David Hume, a Scottish philosopher, has taught us on making a conclusion from our experience: just because in your experience an act is always followed by the second act does not mean that there is a causality between the first act and second act.

In Nassim Nicholas Taleb's wisdom (taken from his book "Fooled by Randomness"): "no amounts of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion." If translated: even after going through 1,000 successfull experiments, you will never be able to claim that a hypothesis is correct with 100% degree of certainty, but it will only need one failed experiment to reject such hypothesis. I agree with both of Hume and Taleb.

Previously, I have made some hypotheses with certain logical reasoning in my blog. Will it always be correct? Of course not! Situation and condition may change or maybe I haven't considered all of the relevant issues and facts, or maybe there is a fallacy within my seemingly fine argument. Mr. Mankiw is correct in saying that the ones who conclude that there is a relationship between family income and better test results might be wrong, but I also dare to say that his conclusion might not be correct either. Are there any relationship between smart people and their incomes, i.e. the smarter you are, the higher your income? I don't know, though I do know some rich stupid people and some poor to average smart people. Further, how many data should we collect before we can make such conclusion? Again, I don't know. My advice is simple, be very careful when we are dealing with statistics as people can always make different conclusions and interpretations from such statistics. When you think that a correlation between facts exists based on a result of a statistic, you better think it through again.

Yes, according to Lucian Bebchuck, a law professor from Harvard Law School. A guaranteed bonus may, to certain extent, create distortion in determining the business risk of a company. By having the benefit to receive a guaranteed bonus no matter what the performance of the company, there would be a considerable pressure for the management to meet the company's business target or even exceed such target. As a result of this, the management may take unnecessary risks in doing the business just for the sake of getting better performance. We need to understand that in some cases, riskier business decisions may provide higher results, but they may also cause greater losses. When the results are losses, who would be the largest victim? The Company and also the shareholders.

Further, Prof. Bebchuk theorizes that if the bonuses of the management were distributed based on the overall performance of the company, say after reaching a minimum amount of annual profit, the management will have better consideration in doing the business, i.e. they would only take the risks if the odd of getting the intended performance are higher than the odd of getting a lower results. Why? Since the management bonuses are now tied to the performance of the company, it would be dangerous for them to take too much risks because if the results are bad, they will also lose their bonuses. As a result, they would play safer.

Again, this shows how incentives work in our life. I would love to see how this will be implemented in Indonesian regulations. While I absolutely don't agree if the regulator is trying to limit the amount of benefits that can be obtained by the management, a policy on how to structure the best benefit package should be okay, provided that companies can freely choose to adopt such policy or not (as will be determined by the shareholders and, if possible, an independent remuneration committee).